Spanish Bonds Risk Forced Selling as Rating Approaches Junk

By Emma Charlton -
Oct 11, 2012

Spanish government bonds are facing a selloff by investors concerned that the nation’s credit rating will be cut to non-investment grade after Standard & Poor’s lowered its ranking for the debt to one level above junk.

Spain’s two-year notes fell for a fourth day, the longest run of declines in six weeks, after New York-based S&P said yesterday it had cut the rating two levels to BBB-. While data compiled by Bloomberg News shows that about half the time government bond yields move in the opposite direction suggested by new ratings, a potential cut to junk may prompt selling by investors who use bond indexes to determine their holdings of fixed-income assets.

Moody’s Investors Service is studying a possible downgrade for Spain from its current Baa3 level, its lowest investment- grade rank, and Fitch Ratings scores the country BBB, two steps above junk.

“Investors now have to reckon with Spain’s average rating going sub-investment grade over the next few months,” Ciaran O’Hagan, head of European rates strategy at Societe Generale SA in Paris, wrote in a research note after the S&P announcement. “Even the prospect of seeing the two major agencies rating Spain below investment grade will lead to widespread selling over the coming month.”

‘Whatever it Takes’

Spain’s two-year note yield climbed one basis point, or 0.01 percentage point, to 3.28 percent at 3:27 p.m. London time. The rate has declined from a euro-era high of 7.15 percent on July 25, the day before European Central Bank President Mario Draghi pledged to do “whatever it takes” to safeguard Europe’s monetary union. It is still above this year’s low of 2.15 percent, reached on March 1.

Ten-year Spanish yields advanced two basis points to 5.83 percent, down from a euro-era record 7.75 percent on July 25.

The nation’s bond market is the seventh-largest among developed nations, at $969 billion, according to data compiled by Bloomberg. Japan’s is the largest at almost $12 trillion, the data shows, while Germany’s is $1.4 trillion.

Mounting Risks

S&P cited mounting economic and political risks for the downgrade, as Spain’s government considers resists requesting a sovereign bailout. The company assigned a negative outlook to the nation’s long-term rating and said euro-region peers’ backtracking on a pledge to sever the link between the government and its banks contributed to the decision.

Spanish bonds are so far still eligible for inclusion in the Barclays Euro Treasury Index, Markit iBoxx Euro-Area Benchmark indexes and Citigroup Inc.’s European Government Bond Index and World Government Bond Index because the nation is rated above investment grade at all three ratings companies.

‘Junk Status’

“We need to wait to see what the Moody’s assessment is before we can get particularly concerned about Spain,” Sarah Hewin, London-based head of research in Europe for Standard Chartered Plc, said in an interview on Bloomberg Television’s “The Pulse” with Maryam Nemazee. “If Moody’s downgrades, then that will pull Spain to junk status.”

Fund managers use indexes as a guide to what percentage of their assets should be invested in certain securities and to measure their performance. Some funds’ guidelines require them to sell holdings of a nation, should it drop out of an index or lose its investment-grade ranking.

The downgrade was unexpected and negative for Spain, Ignacio Fernandez-Palomero Morales, deputy head of the nation’s Treasury, said at a conference in Tokyo today.

“Investors are much less reliant today on ratings than they were several years ago,” Fernandez-Palomero said. “My impression, and we saw that after several rating downgrades in the past, is that investors do not rely so much on ratings today.”

“It doesn’t coincide with the treatment markets are giving to Spanish debt, or with our financing costs,” she said.

Coin-Flip

Predicting the consequences of a rating change by S&P or Moody’s may be little different from flipping a coin, with yields moving in the opposite direction than suggested 47 percent of the time since 1974, according to data compiled by Bloomberg. Yields were measured after a month relative to U.S. Treasury debt, the global benchmark.

France’s 1.08 trillion euros ($1.4 trillion) of debt maturing in a year or more has rallied 8.6 percent since it was downgraded to AA+ on Jan. 13, more than double the gains for the rest of the global government bond market, and beating AAA rated Germany, the U.K., and Australia, according to Bank of America Merrill Lynch indexes. U.S. borrowing costs also tumbled after the world’s biggest economy was stripped of its AAA credit grade in August 2011.

Credit Threshold

The Frankfurt-based ECB said on Sept. 6 that it had suspended its minimum credit threshold for government bonds of nations that request aid. That would allow their debt to be used as collateral to obtain funding in the bank’s refinancing operations even if they are sub-investment grade.

Spanish banks’ net borrowings from the ECB fell in September for the first time in a year, Bank of Spain data showed today. Net borrowings fell to 378.2 billion euros from 388.7 billion in August, the data showed.

“When rating agencies decide to downgrade a country, to speculative grade in particular, there is always some forced selling in the market,” Axel Botte, a Paris-based strategist at Natixis Asset Management, which oversees the equivalent of $711 billion, said in an Oct. 5 phone interview. “The ECB took one step to mitigate this effect by offering to suspend rating requirements for collateral issued or guaranteed by a country that would apply for aid.”

Natixis is neutral on Spain, Botte said.

Index Criteria

Spain’s bonds need to retain investment-grade status at two of Fitch, Moody’s and S&P to be included in the Barclays Euro Treasury Index. The nation’s debt makes up around 10 percent of the index, Scott Harman, an analyst at Barclays in London, said on Sept. 26. That’s the fourth-largest share after France, Germany and Italy.

The securities will stay in Citigroup’s European Government Bonds Index and World Government Bonds index while they are ranked above junk at either S&P or Moody’s. Markit uses its own system for its indexes, based on an average score derived from the ranks given by the three ratings companies.

The lower rating “matters for the holdings of bonds, particularly outside of Spain,” Steven Major, global head of fixed income research at HSBC Holdings Plc in London said in an interview with Bloomberg Television’s “Countdown” with Mark Barton. Some foreign investors “may well be forced to sell if we go below investment grade, but for Spanish banks it won’t make any difference.”

Greek 10-year bond yields jumped 272 basis points in June 2010 as the nation’s debt was ousted from indexes run by Citigroup, Barclays and Markit following downgrades.